The ‘Wild West’ of financing: are ICOs the end of venture capital fundraising?

May 2018 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

May 2018 Issue

Start-ups today have many options to raise capital, with many needing an infusion of funds to get off the ground. Traditionally, new companies would have looked to venture capital (VC) to raise capital and to help their growth plans. Now, however, companies have a new option: Initial Coin Offering (ICO). This nascent fundraising model presents benefits and disadvantages, as well as threats and opportunities, to the traditional VC business model.

Fast-growing technology start-ups are increasingly turning to this model and can raise tens, if not hundreds, of millions of pounds through ICOs without sacrificing any equity, leaving VC funds helplessly on the sidelines with chequebooks in hand.

However, ICOs in their current form are not currently suited to the shareholder wealth-maximising business model. Although an innovative and disruptive method of fundraising, problems can arise which could mean ICOs still fall short of providing a paradigm shift away from traditional dilutive forms of venture capital.

What is an ICO?

ICOs allow companies to fund the development of their blockchain-leveraged services through the sale of tokens, which guarantee coin holders the right to participate in and benefit from the blockchain. Tokens are offered and sold to investors in exchange for legal tender or other cryptocurrencies. Tokens sold in ICOs can be used by the holder to buy future services from the issuer, but carry the additional expectation that they will grow in price proportionate to the success of the underlying project or issuing company. It is an egalitarian method for raising cash for new ventures: investors receive no equity stake or share of future cash flows.

The price of tokens is freely floating, based on market supply and demand for that particular cryptocurrency. As opposed to commodities or fiat money, cryptocurrencies do not have any intrinsic value, do not exist in physical form and their supply is not determined by a central bank. The value is settled on by the network of participants, rather than by a central authority.

The crucial difference between VC and ICOs is that issuing shares is dilutive, whereas issuing tokens is not. Tokens do not give investors any ownership rights or asset claims but instead give users rights related to the specific project itself, not to the company launching the project.

For many founders, there is now a clear fork in the road for financing their companies: continue along a traditional venture capital fundraise path or find a way to jam tokens and blockchain technologies into their business and raise capital through an ICO.

2017 ICO-mania

A boom in interest has increasingly drawn parallels to the hype days of the dotcom bubble. Capital has poured into the ICO frenzy, rivalling the surge in bitcoin. Globally, there were over 230 ICOs in 2017 which totalled around $3.8bn, according to research by Coindesk. That total volume pales in comparison to overall VC funding, which is estimated by Statista at $84.2bn in 2017. However, ICO financing is more comparable with early-stage VC funding. By mid-2017, the pace of ICO fundraising had surpassed angel and seed stage internet VC funding globally (excluding crowdfunding).

So why has money poured in at such an astonishing rate? The appeal of crypto for active investors is that they offer the promise of ‘alpha’ – returns above market averages. Research from Mangrove Capital Partners suggests a blind investment in every ICO to date, including those that have failed, would have generated an average return of 13.2x for investors. With a wall of institutional capital in search of high quality investment opportunities, such eye-watering returns do partly explain why an influx of capital has been funnelled into ICOs.

Benefits of raising funds via ICO

There are five key benefits for a start-up from an ICO funding model. First, ICOs are non-dilutive to equity. For blockchain startups, ICOs allow fundraising without having equity stakeholders breathing down their necks on spending, prioritising financial returns over the general good of the product or service itself.

Second, fundraising via an ICO presents a global, decentralised investment opportunity. ICOs offer a large market to present a company’s tokens to, increasing the likelihood of finding a vast and diverse base of investors.

Third, perhaps the most astonishing aspect of an ICO is the speed at which money can be raised for a project that exists solely as a vision. In June 2017, Mozilla’s founder raised $35m in under 30 seconds for a new web browser start-up named ‘Brave’. The ICO sale window may last up to four weeks, which is scheduled after little more than three months of preparation (from legal to escrow services), thereby presenting quick and relatively ‘easy’ access to capital.

Fourth, ICOs offer increased liquidity via secondary markets. One of the major issues plaguing the traditional VC space is the timeline to realise actual return via IPO or acquisition. With ICOs, however, investors are free to trade their tokens for other projects at any time (after a brief lock-in period), providing liquidity to the holders of tokens.

Fifth, ICOs build a community of evangelists (investors or users) right from the beginning who are also incentivised to spread the message. As a result, the start-up is not just getting capital, but also its first customers. This allows for an alignment of interests of the coin holders with the success of the platform, thereby using the wide investor base to the start-up’s advantage.

Downsides of an ICO: VC still holding strong?

ICOs present various challenges and issues that are not apparent in more typical fundraising methods, such as VC. Typically, ICO projects are in a very early stage of development and their business models are experimental. One of the key benefits of VC fundraising is that a company receives investors’ long-term experience as well as direct financing. ICOs lack the governance structure that comes with traditional fundraising, such as a partner from a VC fund joining the board of directors of a portfolio company.

With an ICO, a start-up misses out on the opportunity to benefit from the network, advice, prestige and governance that a well-established investor would bring. Controls over financials, strategy and operations may therefore be somewhat less scrutinised.

Conducting an ICO may send a negative signal to traditional equity investors that the company failed at fundraising and is therefore choosing the next best alternative. Companies that attempted to raise venture capital six to 12 months ago are seemingly launching ICOs. An online art gallery known as Maecenas, which failed to raise £400,000 through crowdfunding last year, raised $15m a few months later through an ICO.

Inherent and systemic risks

Token sales should be treated with a certain element of caution. It is an environment ripe for scams, and even when founder intentions are good, investors are often placing their trust in nothing more than an idea with a shiny website and hyped-up marketing. By attracting a wider and more diverse pool of investors, there is also a greater burden of compliance on the start-up to undertake Know Your Client and anti-money laundering checks. An added complication is that investors pay in cryptocurrencies, which means that establishing the source of funds is somewhat more complex.

Cyber security threats are increased too. In July 2017, over $7m was stolen in the ICO of CoinDash, and Etherparty was the subject of a similar attack in October 2017, where the address for sending funds to buy tokens was replaced by a fraudulent address controlled by hackers.

Perhaps the largest downside of undertaking an ICO is the regulatory uncertainty of this fundraising technique. At present, if a token is viewed as an investment (in the UK) or a security (in the US), then it requires a full regulatory framework to be lawful. Tensions also exist between the desire of many token holders to see an increase in the token price, and the desire of the promoter to emphasis the utility (or not-for-profit) nature of the venture.

As ICOs have gained popularity, regulators around the globe have taken note. For example, the FCA in the UK recently warned that the area was very high risk, subject to extreme volatility and announced that it is taking a deep look into the rapidly growing market. In the US, the Securities and Exchange Commission (SEC) cautioned investors and start-ups, pointing to substantially less investor protection than in traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.

Furthermore, in late 2017, the SEC filed a fraud suit against an ICO named PlexCoin, with one of its operators thrown in jail. The SEC also halted the ICO of Munchee, on the grounds it was an unregulated security, requiring the start-up’s founders to return the funds they had already raised. In the US, the ‘Howey Test’ establishes that tokens are indeed securities if a reasonable expectation of profits arises.

China has gone even further by banning ICOs entirely, as authorities struggle to tame financing channels that sprawl beyond the traditional banking system. ICOs have been labelled a form of ‘non-approved illegal public financing behaviour’ with raised suspicions of ‘financial fraud, illegal direct marketing and related criminal activity’.

There are some jurisdictions that remain open-minded, though, and have welcomed cryptocurrencies. Belarus has declared itself open to ICOs as of December 2017, with revenues and profits from ICOs not taxed until 2023. A state-sponsored cryptocurrency has been proposed in Estonia to help integrate the booming crypto-economy into the country’s mainstream economic system. New distributed ledger regulations in Gibraltar have made the jurisdiction attractive to ICOs. Trading of cryptocurrencies has been legalised in Russia, whereas Venezuela has launched a national cryptocurrency of its own, backed by oil reserves.

Global regulatory uncertainty, along with cross-jurisdictional authority, ensures clear legal and tax risks lie at the heart of the cypto-fundraising model. ICOs will not continue unabated without eventual oversight and regulation. There is simply too much money, too little transparency, and too few rules governing behaviour. Adding this regulatory risk to your business presents a clear downside that is tricky to mitigate against.

To ICO or not to ICO?

All in all, ICOs present a novel financing solution for blockchain based start-ups. However, ICOs certainly do not present a revolutionary one-size-fits-all solution for all tech start-ups. Token economics are not yet well understood. With all the hype surrounding cryptocurrencies, it is plausible that the volatility and price movements of the tokens provide an unwelcome distraction to an entrepreneur, whose focus should be on progressing and growing his or her business.

Although vast swathes of capital have exponentially poured into ICOs in recent months, investors and entrepreneurs alike should be cautious of speculative bubbles rooted in irrational exuberance. Capital is transient and can vacate an industry as quickly as it poured in if results and return on investment do not materialise as anticipated.

ICOs do serve a purpose in funding blockchain projects, most of which aim to provide open source software and are reliant on achieving critical mass before eventual monetisation (through add-on services). Start-ups and corporations alike may try to shoehorn themselves into a token sale framework (including the likes of Kodak), yet entrepreneurs should be wary of apparent regulatory risks and misunderstandings of token economics.

Token offerings have proved innovative in attracting donations, but ICOs in their current form are not fit for purpose for most start-ups. If investment, rather than donation, is the substance of the intention, it is likely that a conventional ICO is not suited to a start-up striving for shareholder wealth maximisation.

Joe Barnett is an analyst at Livingstone Partners LLP. He can be contacted on +44 (0)20 7484 4674 or by email: barnett@livingstonepartners.co.uk.